Saturday, April 25, 2009

In a note issued late on Thursday, the credit analysts at BNP Paribas argued that “despite a close to 5o per cent drop in equity valuations, equities look not only rich but are significantly mispriced and are a bubble waiting to be pricked.”

Moreover, they contend that equity analysts are “ignoring the tremendous value embedded in investment grade credit.”

Here are some highlights, which include quite a lot of snickering at the “unfathomable” bullishness of equity types:

Over the past equity bubble decade, it has become fashionable for equity analysts to concentrate on Operating earnings as opposed to As Reported earnings, which factor in write-offs and restructuring charges (Charts 1 and 2). While the difference between the two measures was insignificant until the internet bubble, that difference has grown significantly to the extent that operating earnings look like numbers plucked out of thin air with little resemblance to economic reality. As credit analysts, we are taught that, for a given revenue base, rising costs lower profits, raise leverage and lower creditworthiness. How equity analysts can ignore this fundamental credit analysis is unfathomable to us.

Using current valuations, if one were to calculate the P/E multiple on 2009 earnings, one lands up with 14x using operating earnings and 30x using as reported earnings. We will leave investors to make their own judgment but P/E multiples of 30x certainly scream bubble to us.

As for the use of earnings yield, which they deplore as “another false measure”, equity analysts, using the operating earnings measure have also made the argument that earnings yield are significantly higher than 10-year US Treasury yields and hence equities offer value. This relative value comparison is fundamentally flawed on two counts. Firstly, as we have pointed out, operating earnings are not true earnings and secondly the relative value comparison, should be made to corporate bond yields not treasuries, which would be an appropriate apples to apples comparison. Using this measure, clearly it again illustrates the tremendous value in investment grade credit as opposed to equities.

BNP Paribas chart of expected earnings yield with S&P 500 at 850

Every bull and bear cycle is usually characterized by a significant event that anecdotally indicates over or under valuation in equities. The 2007 top was characterized by the generosity of Blackstone, which thought it fit to share its profits via an IPO, the equity piece of a highly leveraged entity and a known liquidity extractor.

The recent secondary offering by Goldman Sachs, could well mark the top of this bear market rally because GS, we believe would only issue equity at these valuations for two reasons, namely because it needed to as losses on its highly illiquid Level 3 assets continue to mount, or because it saw its equity valuation as being grossly overpriced.

The lack of institutional participation and endorsement of this deal, radio silence from Mr. Buffett, who, as a consequence of this deal got diluted and with both Moody’s and S&P maintaining their Negative Outlook despite the equity injection, it points to GS being very opportunistic in exploiting its equity overvaluation and having the need to build a buffer for future losses.

Time will tell, how significant this GS top will be but for now it makes us very wary of equities, especially US financials, as they have become the playground of day-traders.

They also the purported green shoots in mortgage applications - “not a sign of new home purchases but simply refinancing”.

As for commodities and trade, we will simply let the hard data and the charts do the talking here as commodities and the Baltic Dry index continue to show a “U” or “L” shaped recovery with no sign of “V”.